Try Before You Buy

Acquisitions are risky. More fail than succeed because they are used as a financial rather than a strategic tool. They add to sales and profits but do not build superior products or services, barriers to entry, or long-term customer relationships. They build size, not quality.

Faced with an acquisition, most finance directors will automatically commission financial due diligence. Few will bother with commercial due diligence. Commercial due diligence is all about understanding customers, markets and competition – all the things you need to get right for an acquisition to succeed.

MORE COMPREHENSIVE ANALYSIS

Acquirers should always move quickly post-acquisition, and due diligence generally should be structured to help the post-acquisition process. It should always be used as a means of making sure that the planned synergies are realistic. This will indicate the best way of realising them, help you check that the new strategy is viable and tell you what to do if it is not.

Commercial due diligence is no exception and it should, perhaps, focus more on the aftermath than many of the other due diligence disciplines.

Enquiries fall into three categories: market, competitive position and management. The aim is to use all three to assess how the target will perform as both a standalone business and under new ownership (that is, after integration).

REVIEWING THE MARKET

There are two sub-analyses under market:

• Market: size, structure and growth
• Customers: who are they and what do they want?

The risk is that the market might not be growing as quickly or be as big as first thought, or it could be structurally unsuited to making decent returns. Commercial due diligence must therefore segment the market, establish current market sizes, competitive characteristics and drivers, and forecast growth in the segments relevant to the target.

Management interviews and desk research are important, but they are sighting shots at best.

There is no substitute in commercial due diligence for talking to the experts – managers outside the target who are active in the market every day. They include customers, non-customers, competitors, industry observers, suppliers and regulators.

Typical output will be a market model that serves as an input to revenue forecasts in the valuation of the target and feeds into post-acquisition planning.

GOING THE EXTRA MILE

Although financial due diligence will provide much of the information and analysis needed to form a view of commercial prospects, the trouble and expense of conducting commercial due diligence can more than pay off.

First of all, accountants rarely go beyond commenting on the reasonableness of the assumptions behind a forecast and whether it has been added up properly. Because commercial due diligence provides market insight, it underpins a forecast's logic. It also identifies the areas of greatest susceptibility and therefore the sensitivities that should be run as part of the financial modelling.

The second reason is that financial due diligence tends to be internally and historically focused. It collects its market and competitive information from management, it looks into customer churn from internal records, and from those same records makes a judgement on the degree of risk of relying on, say, a small number of customers or a small number of suppliers. What it does not do is go out and test that theoretical risk.

The third reason is that relying on the target's management is not always the best way of assessing future prospects. Companies are notoriously bad at looking outside and, in any case, management is always bound to accentuate the positive. At the very least, if management say their products are the most highly rated by all the important customers in the marketplace, due diligence needs to check with those customers that this is in fact the case – and that it will continue to be the case.

The final reason is that financial due diligence cannot provide the same insights as commercial due diligence. Financials are backward looking. When you buy a company, you are buying its future and its future depends on the health of its market and how well it serves its customers.

In the example in Figure 1, above right, sales have doubled, margin has nearly doubled and ROA has risen from 11% to 30%. Not a bad performance at all, until you look at Figure 2, below right, which summarises market performance.

Hypothetical's growth has lagged, market share has shrunk from 20% to 14% and customer retention has dropped from 88% to 80%. There is something very wrong and it is probably a result of the tactics used to improve the financial performance. Cuts in sales, marketing and R&D expenditure all contribute to short-term financial gains, but undermine the longer-term market position.

Financial due diligence only tells half the story, which is why commercial and financial due diligence should be seen as complementary.

It is strange, then, that commercial due diligence remains the poor relation of financial and legal due diligence when, properly structured, it can tell you so much about what you are getting into with an acquisition.

UNDERSTANDING THE CUSTOMER

In looking at customers, commercial due diligence should address three risks:

• Whether the segments served by the target are shifting
• That the benefits delivered by the product or service are, or will be, better delivered by something (and/or someone) else
• The degree to which the product or service is commoditising

The objective is to establish customers' key purchase criteria and their future buying intentions. To do this, commercial due diligence must first establish who the target's major customers are. It is amazing how revealing a five-year customer history can be. It is also amazing how many target companies are unable to provide one. Commercial due diligence then goes on to establish the target's value, which may not be the same for all of them. The next logical step is to see how the target performs relative to what customers want.

EXAMINING THE COMPETITION

Competitor analysis asks one very simple question: 'does the target have adequate resources and capabilities to survive the competition?' After working out who the major competitors are and the degree of rivalry, commercial due diligence should establish the target's strengths and weaknesses vis-a-vis customer-purchase criteria and the competition's performance. Sellers always claim that they have no competitors. While this is never true, the target's competitive position is improved if it can avoid head-on competition.

Finance directors should be much more concerned with the target's ability to differentiate itself than with cost-based synergies. Differentiation is being different, not just saying something different. The chances of long-term acquisition success are best if the target has a robust and sustainable value proposition that is better than that of the competition, and which it achieves by playing to its strengths, minimising its weaknesses and anticipating competitor moves. The way to establish whether or not this is the case is, once again, through in-depth market interviews.

EVALUATING THE MANAGEMENT

A common cry of bewildered chairmen when a business does badly is: 'is it the man or the market?' This is a question as valid in M&A as it is in monthly reporting. Wonderful market conditions and a differentiated position to die for are no good if management cannot deliver. Filling an entrepreneur's pockets with money, then expecting him or her to continue performing is not always a logical assumption.

Commercial due diligence does not pretend to supplant the more formal management assessments, but it should be encouraged to provide a market-based assessment of the strengths and weaknesses of management, the importance of any key individuals and any missing capabilities.

Commercial due diligence practitioners use a combination of competency-based management interviews and external market interviews to develop an opinion on management.

Due diligence is about much more than assessing the risks that need to be tackled in the deal negotiations. It should also assess the target's strategic fit and fundamental attractiveness, and help ensure excellence in post-merger integration.

Commercial due diligence provides the most important insights on the future of the target and the merged entity. Broadly defined, it is a set of activities involved in evaluating a target company's and merged entity's market, customer relationships, competitive position and strategic direction.

The knowledge gained from this evaluation becomes the critical input for determining the target's value to the acquirer.